Many consumers/borrowers that purchase a home borrow funds from a lender and grant the lender a security interest in the home, which serves as collateral. The legal document whereby the consumer uses the property as collateral for repayment of the loan is commonly known as a mortgage or mortgage loan. Lenders sell many of the mortgage loans that they originate into the secondary mortgage market. The Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (Ginnie Mae) are participants in the secondary mortgage market. By buying mortgage loans in the secondary mortgage market, participants like Freddie Mac provide lenders with capital that allows them to meet consumer demand for additional home mortgages. The secondary market for mortgage loans renders available a supply of money for housing, thus lowering the cost of money and ultimately lowering the cost of home ownership for consumers.
Secondary mortgage market buyers typically either purchase home mortgages for cash or issue securities in exchange for the mortgages. A security that is exchanged for a mortgage loan(s) is known as a mortgage-backed security (MBS). An MBS is typically a pass-through security representing an undivided beneficial interest in one or more pools of mortgage loans. An MBS is called a pass-through security because the borrowers' payments of principal and interest are passed through to holders of interests in the MBS. In general, a mortgage pool is a positively identified group of mortgage loans combined for resale to individuals or entities. An MBS may be backed by mortgage loans originated by one or more lenders.
The process of forming the mortgage pools and issuing an MBS is called securitization. MBSes, like most securities trading in the United States, are assigned a CUSIP (Committee on Uniform Securities and Identification Procedures) identifier, which is a unique nine-character identifier that uniquely identifies the security. A CUSIP number is like a serial number; each individual security traded in the US market, such as an MBS, has a different CUSIP number that uniquely identifies it.
Conventional MBSes have been available for some time. The Tax Reform Act of 1986 (TRA 1986) eliminated many of the tax advantages of traditional real estate ownership and syndication, but offset this in part by creating an innovative tax structure that changed the way real estate mortgages could be held. The TRA 1986 authorized the creation of real estate mortgage investment conduits (REMICs) as a vehicle for creating multi-class, pass-through MBSes that resolved certain tax and balance sheet problems associated with a mortgage security called a “collateralized mortgage obligation” or CMO. A REMIC is an investment-grade mortgage security that separates mortgage pools into different maturity and risk classes and serves as a conduit for holding the mortgage pools that back it. Cash flows derived from payments of principal and interest on the underlying mortgages are passed through the REMIC structure to holders of bonds representing each REMIC class, with no income tax consequences to the REMIC structure itself.
Several years after the first REMICs were formed, secondary mortgage market buyers began to combine previously securitized, single-class MBSes to form new and larger securities backed by the assets of two or more MBSes to form a “Giant MBS.” A Giant MBS is a single-class pass-through security formed by combining individual MBSes (or portions of MBSes) with other MBSes (or portions of MBSes). Giant MBSes may be known by other names throughout the industry; For example, Fannie Mae refers to a similar MBS as a “Mega.”
Giant MBSes allow investors to manage their portfolios efficiently by consolidating smaller MBSes into one security. For example, an investor holding a portfolio of 100 smaller MBSes, each a separate security, has to track and account for 100 different CUSIP numbers. If the investor combines the 100 MBSes into a single Giant MBS, however, the investor has to track and account for only the single CUSIP number assigned to the Giant MBS. Forming a Giant MBS greatly reduces the internal processing and accounting costs for tracking the balance and monitoring the monthly payments associated with underlying mortgage investments, compared to the costs associated with several smaller MBSes that each pay on different schedules and may amortize at different rates. It is more economical to receive periodic payments by wire from a single Giant MBS than to receive multiple wire payments from multiple MBSes. Giant MBSes are also large and highly liquid, making them more attractive to some investors than smaller MBSes.
Other benefits of investing in Giant MBSes include: lower borrowing and security administration costs resulting in standardized pricing; increased market liquidity; ease of trade execution; and the ready availability of comprehensive disclosures.
Giant MBSes also lower an issuer's internal processing and accounting costs because it is easier to track the balance and monitor the monthly payments for one large pool of mortgage loans rather than multiple smaller pools of mortgages. From the MBS administrator's or servicer's point of view, the economies of scale result in lower administration and transaction costs associated with the larger pool of underlying mortgage loans, and therefore dealers and financial institutions are able to charge lower rates for administration.
Moreover, by forming Giant MBSes, issuers may combine odd-sized MBSes and achieve the more standardized pricing available for large pools, such as those with aggregate loan balances in excess of $1,000,000. Giant MBSes are also more attractive to the market than smaller pool MBSes because they are more likely to meet the Bond Market Association's (BMA's) “good delivery” guidelines. The good delivery guidelines require each delivered security to meet a minimum original balance (e.g., $25,000) and have a predefined range of final maturity dates, depending on the types of securities. For example, for some 30-year securities, the predefined range of maturity dates at issuance is between 181 and 361 months to maturity; for some 15-year securities, the maturity dates must not exceed 181 months, and for other 30-year securities, there must be at least 28 years remaining from the date of issuance.
As noted above, a Giant MBS commonly contains a pool(s) of mortgage loans that generates multiple types of cash flows. Conventional REMIC classes are backed or partially backed by an undivided prorata portion of a Giant MBS, which may be prorata subdivided into risk and maturity classes. In other words, a REMIC holder receives a slice of a Giant MBS that represents a portion of the Giant MBS as a whole, such as an undivided 10% interest in the Giant MBS. A conventional REMIC class is not associated with any specific group of loans or individual loan in the pool (i.e., a subpool) that backs the Giant MBS, such as an identified loan group that includes only mortgages with certain specified characteristics (for example, mortgage loans that were originated in Florida). A conventional REMIC cannot separate cash flows from specific subpools of mortgages contained in a Giant MBS from the overall cash flow of the Giant MBS, and a prospective REMIC holder cannot specify the characteristics of the individual mortgage loans backing a REMIC.
As a result, the value of mortgages with more favorable or more desirable characteristics in a Giant MBS is adversely affected by mortgages with less favorable or less desirable characteristics, and the total value of the Giant MBS is reduced because the market tends to value the Giant MBS as a whole based on its least desirable parts.
One way this problem might be solved is by collapsing a Giant MBS and reforming the underlying parts. For example, in order to form an MBS that contains specific mortgages, a Giant MBS and its constituent parts (whether MBSes or pools) could be disaggregated and the mortgages reformed into at least two new pools, one of which could be resecuritized into an MBS backed by desired mortgages. REMIC classes based on the new MBS could then be issued for the desired cash flows, for example, cash flows from mortgage loans that were originated in Florida.
Collapsing a Giant MBS and issuing new MBSes and REMIC classes, however, has several drawbacks. For example, a Giant MBS may not be disaggregated into its constituent pools without the consent of all holders. In many cases, gaining the consent of all holders is difficult. Another drawback is that disaggregation fragments the market by producing several small, specialized MBSes, some of which may be undesirable to investors. Another problem is that most of the benefits associated with a Giant MBS, such as size, liquidity, and transparency, are lost by disaggregation. Moreover, the process is inefficient due to costs associated with collapsing the Giant MBS and higher servicing costs associated with forming and maintaining the new MBSes.
Accordingly, it is desirable to separate cash flows having certain characteristics from a Giant MBS to support new MBSes, and to make those cash flows available to investors who want to invest in mortgage loans having only those characteristics. It is also desirable to issue MBSes (e.g., REMIC classes) backed by the cash flows from particular specified mortgages within a Giant MBS without collapsing the Giant MBS. It is also desirable to separate the cash flows generated by loans having certain desirable characteristics in a manner that maximizes as much as possible the benefits from new MBSes backed by those cash flows.